I had the opportunity to chat recently with Matthew Claassen (CMT) about his views on the market and what he sees ahead. Matthew’s work caught my attention because he turned bullish early on in 2009 when very few did so. As well, one of the indicators that helped him at that time was the same one we’ve been discussing here for a while: the distance from long term trend.
Of course, there is much more insight and charts so let’s get started:
TN] Hi Matthew, for those who are not familiar with your work and background, can you tell us a little about yourself?
MC] First off; thank you for the opportunity to be a part of your blog. I’ve been managing portfolios and advising professionals since 1986. I hold the professional designation of Chartered Market Technician (CMT) and am a past Director of the Market Technicians Association (MTA).
Previously I was the editor of “The Technical View” a market newsletter which was subsequently bought out by Lowry Research in 2004. I joined the firm and was the Senior Vice President of Lowry Research. Currently, my company’s name is Claassen Research where I provide two services strictly for institutional portfolio managers; weekly commentary in a publication I simply call my Market Update and private advisor retainer. The weekly commentary is $15,000/year. The private consultation/retainer is $50,000/yr. If you’re interested to learn more, you’ll find more details on my site.
TN] The March 2009 bottom took many by surprise, including the very respected firm of Lowry where you worked at before. But you recognized that an important inflection point was about to occur. How did you do realize that and what indicators were you looking that helped you?
MC] In retrospect, the March 2009 low was one of the easier market calls I have made in the twenty five years I’ve been involved in the markets. My decision to tell subscribers to prepare for a rally was a combination of three concepts; two indicators and one study.
In February, 2009 the market was approaching 40% below its 200 day average. That’s more extended than at any time since 1932, and just slightly more than the 1937 decline. That illustrated a powerful fear had taken hold of investors. The contrarian in me felt that regardless of the long term trend, the market was unlikely to sustain such powerful downside momentum. In addition, I had previously completed a study of multi month bear market rallies from 1960 through 2008. There were several interesting concepts that came out of that study, but what was most pertinent was that approximately 40% of all multi month bear market rallies started in March. We all know that the number one bear killer month is October, more bear markets have ended in October than any other month. However, many investors are surprised to hear that March comes in as a relatively close second. Thus, any time the market is declining sharply into the months of October or March, investors should look for signs of a potential bottom.
Lastly, I keep a measure of both Buying Volume and Selling Volume for the broad market, major economic sectors and select international markets. When monitoring Buying and Selling Volume we can typically see a rise in Selling Volume in the weeks ahead of a major market top. The increased Selling Volume is an indication of the investor profit taking into a rally that often precedes a market turn. Conversely, as a market approaches sustainable bottoms we typically see rising Buying Volume, which indicates that prices have fallen far enough to spark investor interest and create demand. In the case of the March, 2009 low; Buying Volume in the US broad market has shown some signs of life going into the November, 2008 low, but really started to pick up steam in early February, even though the market was declining sharply. Investors had started buying into weakness.
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So combining the fact that the market was extremely oversold relative to its 200 day average, that 40% of multi-month bear market rallies start in March and that Buying Volume was increasing all came together as part of the decision. To be fair, I had no idea that the market would rally 70%. My view was that the market would at least rally for a couple months and recover about 38% of the decline. But that meant switching from short to long and letting the market tell us how long the ride would last.
TN] This cyclical bull market (since March 2009) has been one of the most hated ones I’ve seen in my time. Most traders and investors have persistently denigrated it or ignored it as we can see in the lack of mutual fund inflows (and actual outflows!). However, at the same time we have seen some extreme bullish readings in sentiment surveys, especially most recently at the end of the year and start of the new year. How do you reconcile these two conflicting elements?
MC] That’s a great question. I believe that the poor disposition some investors have had toward the market is a reflection of the lack of confidence in the long term outlook, while the bullish readings are a reflection of what the market has accomplished since the March low. I believe sentiment indicators do have value. However, this conflict is a perfect example of why investors should simply focus on the technical aspects of the market that tell us what is happening, rather than what some believe should happen.
A perfect example of this is the persistent low total volume that has plagued this rally for months. We all know that low volume as a market advances is historically bearish, and yet we have experienced one the sharpest gains in market history. If, rather than focusing on total volume we divide volume into Buying Volume and Selling Volume we can see that Buyers have controlled this market from the beginning. I consider Buying Volume the most reliable surrogate measure of investor demand and Selling Volume the best measure of investor supply. Simply put, markets rise when demand is greater than supply. It doesn’t matter if both are falling or both are rising. It is the ratio of demand to supply that defines the trend, not the level. We can see that in the chart below, where both Buying and Selling Volume have been in a down trend since mid-May. But, Buying Volume has persistently outpaced Selling Volume, leading to higher prices. We can also see that the strength of Buying Volume relative to Selling Volume has been weakening since late October, reflecting a tiring trend.
TN] What are your thoughts on the allegation made by Charles Biderman of TrimTabs that the Federal Reserve is manipulating the market by buying futures?
MC] Well, as far as monitoring where the buying has come from, I don’t know of any group that has the resources to match TrimTabs. I am in no position to argue against his findings. However, because his conclusions are based on a process of elimination rather than hard evidence, it will always be controversial.
TN] In your January mid-month market update, you wrote:
The broad market’s intermediate trend remains positive as the major market indices continue to post higher highs and higher lows. While we expect the intermediate trend to eventually run into headway, there is little indication of the increased broad market profit taking that typically precedes an important market top. That said, we do see signs of skittishness within the trading of numerous individual securities. It seems investors are quick to take profits in stocks that have advanced sharply, preferring to sell breakouts and buy pullbacks.
The much awaited correction finally arrived last week. From a short term perspective, how do you see it playing out and what are some of the indicators that you will be using to monitor it? is this it for the aging rally? or do you think it is still ongoing?
MC] Interesting that you say: “The much awaited correction finally arrived last week.” It seems that market sentiment has gone from overly bullish to “This is it” overnight, and that has my contrarian sensors all lit up. The market has only been down for three days.
I have been saying since November 20th that over the intermediate term prices should be lower than they were at the end of 2009 and start of 2010. But in the short term there was very little of the typical signs of profit taking that precede a major market top. In fact, Selling Volume was increasing for only about a week leading into this top. Last week the market suffered its strongest three day decline since before the market rally started in March. The S&P has violated its uptrend line from the June low while holding above and testing a smaller uptrend line from August. The Dow Jones Industrial has closed below its uptrend support. Obviously something has changed and I believe the probabilities are strong that the broad market indices will test their 200 day average in the weeks ahead.
The big question most investors have is “is this the end of the rally from March or just a meaningful interruption?” Unfortunately, in the investment world the only certainties we work with is what has already happened. From an investment management point of view this is a time to hedge the long positions you want to keep and build short positions in the weakest parts of the market. From there we will see how far this market will take us before buyers start to accumulate positions again.
As far as indicators are concerned, I will be watching a few things that might help us determine the strength and potential longevity of this decline. One indicator I will watch closely is Breadth. There are many ways to monitor market Breadth. The Advance Decline Line is one. However, the Advance Decline Line has not been a leading market indicator since before the 2000 top. I prefer to watch an indicator developed by Dr. Marty Zweig many years ago called Breadth Thrust. My own twist is to overlay a 50 day moving average on top his Breadth Thrust indicator.
As a side note, Breadth Thrust is simply a 10 day average of Advances / (Advances + Declines). This is from an old introduction to the Breadth thrust. I am not sure when it was written, but I know it was in the 1990’s:
According to Dr. Zweig a Breadth Thrust occurs when, during a 10-day period, the Breadth Thrust indicator rises from below 40 percent to above 61.5 percent. A “Thrust” indicates that the stock market has rapidly changed from an oversold condition to one of strength, but has not yet become overbought.
Dr. Zweig also points out that there have only been 14 Breadth Thrusts since 1945. The average gain following these 14 Thrusts was 24.6 percent in an average time frame of 11 months. Dr. Zweig also points out that most bull markets begin with a Breadth Thrust.
If the current weakness is the beginning of a decline that will be more than just to test the 200 day average or a 38% retracement of recent gains, then I would expect to see a stronger negative reaction than how the indicator reacted in October, and the follow through should be consistently weak enough to bring the 50 day average below 50. In other words, strong selling is not followed by very strong buying. This would be similar to how the indicator responded at the top in 2007 and in 2000.
TN] We’ve been discussing the ratio of new highs as a yard stick to help us to find major market tops. Is this something that you watch? if so, how do you interpret it right now?
MC] I do monitor New 52 Week Highs and Lows, but perhaps differently than most. Like many investors with an economics background, I like to divide my indicators up into three categories; leading indicators, coincident indicators and lagging indicator. Each has an important role to play in determining a change in trend and the sustainability of the trend. I view New 52 Week Highs and Lows as a lagging indicator that confirms a trend. If your leading and coincident indicators have fallen in line with the markets trend change, when a lagging indicator like New Highs confirm an uptrend or increased New Lows confirm a downtrend, you can have confidence the trend is sustainable
TN] Taking a broader look, where are we in terms of market cycles? is this a real bull market? or are we still within a long term secular bear market that isn’t quite finished?
MC] Back in early 2000, when I was a portfolio manager, I wrote an article for current clients that defined my views on secular bull and bear markets because at that time I believed the secular bull market was about to end. Historically, the US equity markets have changed secular trends about every 18 years.
Then, in 2002 I wrote a piece that I called “The Three Bears” that detailed the differences between three different types of bear markets (Inflationary Secular Bear, Deflationary Secular Bear and Cyclical Bear). The approximate 18 year period is important because historically the investment losses in secular bear markets have been significant enough that it takes an entire new generation of investors that did not experience those losses to step in and generate the demand needed for a new secular bull market.
In brief, I believe a secular bull market is a period of time where the earnings trend and the trailing P/E ratio trend are expanding. Historically, the price gains in secular bull markets are due more to an expanding P/E ratio than increased earnings. I also consider the trailing P/E ratio to be a long term sentiment indicator.
One need only look at the trend in earnings growth since 2007 and we can tell this is not a secular bull market. Also, historically new secular bull markets start with a trailing P/E ratio below 10 and rising earnings. In other words, market sentiment was declining enough to drive the P/E ratio to an extreme low despite improved earnings. At the end of secular bear markets it was the rising earnings plus a weak market that brought the P/E ratio to below 10. The current market has not even come close to approaching these historical norms.
This means the US equity market is still in a secular bear trend and how it behaves from here will depend a lot on whether there are underlying inflationary or deflationary pressures. Past inflationary bear markets have seen a declining real rate of return of near 80%, but maximum nominal declines closer to 50%. Two periods where this occurred was the 1906-1921 inflationary secular bear and the 1968 -1982 inflationary secular bear market. Deflationary bear markets tend to also have 80% real loss coupled with an 80% nominal price decline. That was the case in the US market from 1929 - 1932 and in the Japanese market from 1990 – 2003.
At this point, all I can say about the US secular bear market is that it appears to be a combination of both past inflationary and deflationary bear markets. As such, I expect we are in uncharted territory.
TN] Thank you very much for your time Matthew, that was very enlightening.
MC] Thank you.
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